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Mortgage REIT ETFs in Focus on Renewed Taper Concerns

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With a deluge of positive economic data including ISM surveys, better-than-expected advance third-quarter GDP numbers and a surprising pickup in U.S. job growth in October – all braving the much-hyped ‘shutdown’ – taper concerns have resurfaced.

‘QE Taper’ and ‘rising interest rates’ have become synonymous in the market and fluctuation in interest rate regulates the fate of the U.S. Real Estate Investment Trust (REIT) sector. This is especially true in a high volatility corner of the market known as the mortgage REIT or mREIT space (read: A Comprehensive Guide to REIT ETFs).

Mortgage REITs in Trouble?

mREITs generally use a short-term loan to purchase long-term securities and generate revenues from the spread between the two. Therefore, to make profits, these firms need a wide spread between the short and long-term rates. These firms are typically highly leveraged and more vulnerable to interest fluctuations than most in the REIT world.

However, securities in this space boast some of the highest yields in the equity market. This is because mREITs must pay out at least 90% of their earnings to holders for a favorable tax treatment. Also, its leveraged nature makes it a high-yielding investment proposition.

Now that the U.S. economy has grown 2.8% in the third quarter – the highest this year – exceeding the preceding quarter’s growth rate of 2.5%, the possibility of the Fed’s QE taper came into the picture. Also, a high job growth reading of 204,000 in October added to the speculation of a taper.

The commitment rate for 30-Year Fixed-Rate Mortgages that took a breather following the ‘taper hold’ in late September, crept up 6 bps to 4.16% in early November on a week-over-week basis.

Notably, the rate has seen a steady run since April when it was low at 3.45%. On the other hand, The U.S. 5-year treasury yield rose to the highs of 1.47% (as of November 12, 2013) from the lows of 0.76% at the start of the year.

If the scenario persists and short-term rates rise faster than the medium-to-long term rates following tapering, the spread between two will shrink thus hurting profit margins of mREIT companies.

Given this, investors should be at least a little concerned about the current state of the mREIT ETF market. These funds might be interesting short-candidates (or at least funds to avoid) for those who believe a taper is coming, or a solid contrarian play for investors who think that a reduction in QE isn’t coming anytime soon.

It is one of the most popular mREIT ETFs in the market with about $1.0 billion in AUM. Average trading volume of more than one million shares a day also makes this fund liquid for investors. The ETF tracks the FTSE NAREIT All Mortgage Capped Index and holds 34 securities in its basket.

The product charges investors 48 basis points a year in fees. The dividend yield – the focus of the fund –was a robust 15.84% (as of November 11, 2013). In last one-year period ending September 30, 2013, REM lost about 8.38% while in last three months it shed about 3.96% (as of November 11, 2013). REM currently carries a Zacks ETF Rank #4 (Sell).

This fund follows the Market Vectors Global Mortgage REITs Index. This one is an overlooked choice with just $93.6 million in AUM and average volumes of about 90,000 shares per day. As compared to REM, this is a bit cheaper option as investors need to spend 40 bps annually for this fund.

Dividend yield is however noteworthy having paid 11.41% on November 11, 2013. In last one year ending September 30, 2013, REM lost about 8.38% while in last three months it shed about 3.85% (as of November 11, 2013).

Bottom Line

Sooner or later, ‘taper’ is on the way and it will send the mREIT sector on even more of a roller-coaster ride than what we have seen so far. But even if the Fed’s taper is not put into effect this year, the uncertainty about the future course of the Fed’s action will likely keep interest rates and mortgage spreads volatile thus affecting the results of mREIT ETFs.

In such a backdrop, risk tolerant investors might bank on the aforementioned funds just to reap the benefits of dividend yields. Otherwise, chances of capital appreciation in the near future look feeble in this troubled corner of the market.

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